Pricing & Valuation Flashcards

Which of the following is least likely a factor in the pricing of derivatives?

Answer: Risk premium required by the investor

Derivative pricing models, such as the Black-Scholes model, typically rely on factors like the underlying asset's price, strike price, time to expiration, volatility, and the risk-free interest rate. While an investor's individual risk premium influences their decision to buy or sell, it is not a direct input into the theoretical pricing of the derivative itself. Derivative pricing assumes a risk-neutral world for calculation purposes.

What is the intrinsic value of a call option?

Answer: The amount by which the option is in-the-money

The intrinsic value of a call option is the immediate profit an option holder would realize if they exercised the option right now. For a call option, this occurs when the underlying asset's price is higher than the strike price. Specifically, it is calculated as the greater of (underlying asset price - strike price) or zero, representing the "in-the-money" portion.

Which model is commonly used to price European options?

Answer: Black-Scholes model

The Black-Scholes model is a widely recognized and fundamental mathematical model used to estimate the theoretical price of European-style options. It takes into account factors like the underlying asset's price, strike price, time to expiration, volatility, and the risk-free interest rate. While other models exist, Black-Scholes is a cornerstone for European option valuation.

What does the 'Delta' of an option represent?

Answer: Change in option price for a $1 change in the underlying asset's price

Delta is one of the "Greeks" in option pricing and measures the sensitivity of an option's price to a change in the underlying asset's price. A delta of 0.50 for a call option, for instance, means the option's price is expected to increase by $0.50 for every $1 increase in the underlying asset's price. It is a crucial measure for hedging and understanding an option's directional exposure.

In the context of option pricing, what does 'Theta' measure?

Answer: Time decay of the option's value

Theta, another of the "Greeks," measures the rate at which an option's value erodes over time, assuming all other factors remain constant. As an option approaches its expiration date, its time value decreases, and Theta quantifies this daily decay. This is because there is less time for the underlying asset's price to move favorably for the option holder.